Why are financial intermediaries special

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Chapter
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Why Are Financial Intermediaries Special?
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Why Are Financial Intermediaries Special?

• Objectives
• Explain the special role of FIs in the financial
  system and the functions they provide.
• Explain why the various FIs receive special
  regulatory attention.
• Discuss what makes some FIs more special than
  others.

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Without FIs
Corporations (net borrowers)
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FIs Specialness

• Without FIs Low level of fund flows.
• Costly for individuals to monitor borrowers
• Role of bond covenants in partially alleviating
  monitoring costs
• Less liquidity
• Substantial price risk

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With FIs
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Functions of FIs

• Brokerage function
• Acting as an agent for investors
• e.g. Merrill Lynch, Charles Schwab
• Reduce costs through economies of scale
• Encourages higher rate of savings
• Asset transformer
• Purchase primary securities by selling financial
  claims to households
• These secondary securities often more marketable

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Role of FIs in Cost Reduction

• Information costs
• Investors exposed to Agency Costs
• Role of FI as Delegated Monitor (Diamond, 1984)
• Shorter term debt contracts easier to monitor
  than bonds
• FI likely to have informational advantage

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Role of FIs in Cost Reduction

• Liquidity and Price Risk
• Secondary claims issued by FIs have less price
  risk
• FIs have advantage in diversifying risks
• SL debacle of 1980s linked to inadequate
  diversification of SLs

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Other Special Services

• Reduced transaction costs
• Maturity intermediation
• Transmission of monetary policy.
• Credit allocation (Areas of special need such as
  home mortgages).
• Intergenerational transfers or time
  intermediation.
• Payment services (FedWire and CHIPS).
• Denomination intermediation.

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Specialness and Regulation

• FIs receive special regulatory attention.
• Reasons
• Special services provided by FIs in general.
• Institution-specific functions such as money
  supply transmission (banks), credit allocation
  (thrifts, farm banks), payment services
  (banks,thrifts), etc.
• Negative externalities arise if these services
  are not provided.

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Regulation of FIs

• Important features of regulatory policy
• Protect ultimate sources and users of savings.
• Including prevention of unfair practices such as
  redlining and other discriminatory actions.
• Ensure soundness of the system as a whole.
• Regulation is not costless
• Net regulatory burden.

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Regulation

• Safety and soundness regulation
• Regulations to increase diversification
• Minimum capital requirements
• Guaranty funds
• FDIC Bank Insurance Fund (BIF), Savings
  Association Insurance Fund (SAIF)
• Securities Investors Protection Fund (SIPC)
• Monitoring and surveillance.

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Web Resources

• For information on regulation of depository
  institutions and investment firms visit
• FDIC www.fdic.gov
• SIPC www.sipc.org
• Federal Reserve www.federalreserve.gov

Web Surf
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Regulation

• Monetary policy regulation
• Federal Reserve directly controls outside money.
• Bulk of money supply is inside money (deposits).
• Reserve requirements facilitate transmission of
  monetary policy.

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Regulation

• Credit allocation regulation
• Supports socially important sectors such as
  housing and farming.
• Requirements for minimum amounts of assets in a
  particular sector or maximum interest rates or
  fees.
• Qualified Thrift Lender Test (QTL).
• Regulation Q.

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Regulation

• Consumer protection regulation
• Community Reinvestment Act (CRA).
• Home Mortgage Disclosure Act (HMDA).
• Effect on net regulatory burden.
• Potential extensions to other FIs such as
  insurance companies.

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Regulation

• Investor protection regulation
• Protections against abuses such as insider
  trading, lack of disclosure, malfeasance, breach
  of fiduciary responsibility.
• Key legislation
• Securities Acts of 1933, 1934.
• Investment Company Act of 1940.

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Regulation

• Entry regulation
• Level of entry impediments affects profitability
  and value of charter.
• Regulations define scope of permitted activities.
• Effects size of net regulatory burden.

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Web Resources

• For more information on regulation of depository
  institutions visit
• www.ffiec.gov
• www.federalreserve.gov
• www.fdic.gov
• www.occ.treas.gov

Web Surf
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Changing Dynamics of Specialness

• Trends in the United States
• Decline in share of depository institutions.
• Increases in pension funds and investment
  companies.
• May be attributable to net regulatory burden
  imposed on depository FIs.
• Technological changes affect delivery of
  financial services and regulatory issues

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Global Issues

• Increased competition from foreign FIs at home
  and abroad
• Mergers involving worlds largest banks
• Mergers blending together previously separate
  financial services sectors